Practical Investment Management by Robert.A.Strong slides ch17

8/14/2019 Practical Investment Management by Robert.A.Strong slides ch17

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THE ROLE OFDERIVATIVE ASSETS

CHAPTER SEVENTEEN

Practical Investment Management

Robert A. Strong


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South-Western / Thomson Learning 2004 17 - 2

Outline

Background The Rationale for Derivative Assets Uses of Derivatives

The Options Market Options Terminology The Financial Page Listing The Origin of an Option

The Role of the Options Clearing Corporation Standardized Option Characteristics


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Outline

The Futures Market Futures vs. Options Market Participants Keeping the Promise

Categories of Futures Contracts

Financial Futures Stock Index Futures

Interest Rate Futures Foreign Currency Futures


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Outline

Derivative Assets and the News Current Events Risk of Derivative Assets Listed vs. Over-the-Counter Derivatives


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Derivative assets get their name from thefact that their value derives from someother asset.

The best-known derivative assets arefutures and options contracts.

Derivatives are not all the same. Some areinherently speculative, while some are

highly conservative.

Introduction


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Background :The Rationale for Derivative Assets

The first organized derivativesexchange in the United States

was developed in order to bringstability to agricultural prices, byenabling farmers to eliminate orreduce theirprice risk.


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Background : Uses of Derivatives

Risk management: The equity managersmarket risk or the bond managers interestrate risk is analogous to the farmers pricerisk.

Risk transfer: Derivatives provide a meansfor risk to be transferred from one personto some other market participant who, for aprice, is willing to bear it.

Derivatives may provide financial leverage.




Income generation : Some people usederivatives as a means of generatingadditional income from their investmentportfolio.

Financial engineering: Derivatives can bestable or volatile depending on how theyare combined with other assets.

Whats next?




Insert Figure 17-1 here.



Options Terminology

A call option gives its owner the right to

buy a specified quantity of the underlyingasset at a set price within a set time period.

Aput option gives its owner the right to

sell a specified quantity of the underlyingasset at a set price within a set time period.

The set price is called the striking price or

exercise price, and the last day the optionis valid is called the expiration date.

The price of the option is the premium.



Options Terminology

Options trade in units called contracts, each of

which normally covers 100 shares.

An options volume indicates how many option

contracts changed hands over some period of

time. It measures trading activity. An options open interestindicates how many

option contracts exist. Open interest goes up when someone creates an

option and does down when two people trade and

each close out an options position.



The owner of an option will ultimately doone of three things with it:

sell it to someone else;

let it expire; or

exercise it.

Options Terminology



The Origin of an Option

Options can be created, or destroyed. The

quantity of options in existence changeseveryday.

The first trade someone makes in aparticular option is called an opening

transaction. If an investor sells an optionas an opening transaction, it is calledwriting the option.

Options are fungible, meaning that, for agiven company, all options of the sametype with the same expiration and strikingprice are identical.



The Role of the Options Clearing Corporation

OCC

Buyer Seller Trading Floor

The Options Clearing Corporation positions

itself between every buyer and seller and actsas a guarantor of all option trades.



Standardized Option Characteristics

Options have standardized expiration dates,striking prices, and lot size.

option premium = intrinsic value + time value

If an option has no intrinsic value, it is out-of-the-money. Otherwise, it is eitherin-the-moneyorat-the-money.


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IntrinsicValue

Time Value OptionPremium+ =

Components of an Option Premium


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AnAmerican option can be exercised

anytime prior to the expiration of the option.A European option, on the other hand, canonly be exercised at expiration.

The option holder decides if and when toexercise.

Valuable options are usually sold rather than

exercised.


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Fig 17-4 here


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The initial seller of the contract promises todeliver a quantity of a standardized commodity toa designated delivery point during a certain

delivery month. The other party to the trade promises to pay a

predetermined price for the goods upon delivery.

The person who promises to buy is said to belong, while the person who promises to deliver issaid to be short.

The Futures Market

A futures contractis a promise.


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The Futures Market

Futures vs. options : Futures contracts do

not expire unexercised. Note that thecontract obligation may be satisfied bymaking an offsetting trade.

Market participants : Hedgers use futures to reduce price risk.

Speculators assume risk in the hope of

making a profit. Marketmakers provide liquidity for the

marketplace.


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The Futures Market

Insert Figure 17-5 here.


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Financial Futures : Stock Index Futures

A stock index future is a promise to buy orsell the standardized units of a specificindex at a fixed price at a predeterminedfuture date.

Unlike most other commodity contracts,there is no actual delivery mechanismwhen the contract expires. For practicality,

all settlements are in cash.


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Financial Futures : Stock Index Futures

Insert Table 17-2 here.


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Financial Futures : Interest Rate Futures

Interest rate futurescontracts are

customarily grouped into short-term,intermediate-term, and long-termcategories.

The two principal short-term contracts areEurodollars and U.S. Treasury bills.

The Treasury bill futures contract calls for

the delivery of $1 million par value of 90-day T-bills on the delivery date of thefutures contract.


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The contract on U.S. Treasury notes is the

only intermediate-term contract, whileTreasury bonds are the principal long-termcontracts.

The Treasury bond futures contract callsfor the delivery of $100,000 face value ofU.S. Treasury bonds with a minimum of 15years until maturity (and, if callable, with a

minimum of 15 years of call protection).Bonds that meet these criteria are said tobe deliverable.


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invoiceprice

settlementprice

conversionfactor

accruedinterest= [ x ] +

Bonds are standardized as follows:

T-bonds are not all fungible. At any given time,several dozen bonds are usually eligible fordelivery on a T-bond futures contract.

Normally, only one of these bonds will becheapest to deliver.


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Financial Futures : Foreign Currency Futures

Foreign currency futures contracts call for

delivery of the foreign currency in thecountry of issuance to a bank of theclearing houses choosing.

Most major corporations face at least someforeign exchange risk and quicklydiscovered the convenience of thesefutures as a hedging vehicle, while

speculators saw the contracts as easy tounderstand and use.


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Derivative Assets and the News

Newspapers in recent months havebeen full of reports on variousbusinesses that have lost billionsinvesting in derivatives.

Derivatives are neutral products. Their riskdepends on what an investor does withthem.

Exchange-traded derivative assets andover-the-counter derivatives are markedlydifferent.


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Review

Background The Rationale for Derivative Assets

Uses of Derivatives

The Options Market Options Terminology The Financial Page Listing

The Origin of an Option

The Role of the Options Clearing Corporation



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Review

The Futures Market Futures vs. Options Market Participants

Keeping the Promise

Categories of Futures Contracts

Financial Futures Stock Index Futures

Interest Rate Futures Foreign Currency Futures


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Review

Derivative Assets and the News Current Events

Risk of Derivative Assets

Listed vs. Over-the-Counter Derivatives


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Appendix: Option Pricing

Fig. 17A-1


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Black-Scholes Options Pricing Model

Insert table 17A-1


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Insert fig. 17A2


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Delta: the change in option premium

expected from a small change in the stockprice, all other things being equal

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Practical Investment Management by Robert.A.Strong slides ch17